Soft Budget Constraints in Romania: Measurement, Assessment, Policy * Lucian Croitoru Center for Romanian Economic Policies 45A Paris Street, Sector 1, Bucharest lcroitor@itcnet.ro Mark Schaffer Centre for Economic Reform and Transformation Department of Economics, School of Management Heriot-Watt University, Edinburgh EH14 4AS m.e.schaffer@hw.ac.uk March 2000 Revised November 2000 1. Introduction The aims of this paper are two-fold. First, we use a comprehensive dataset of Romanian firms covering the period 1995-998 to analyze how loss-making Romanian firms finance their losses. The main questions we seek to answer are the following: What is the scale of the soft budget constraint (SBC) phenomenon in Romania? From which creditors do loss-making firms obtain financing? Are creditors willing to finance firms that are known to be performing poorly? And, if so, which creditors are participating in the bailout process and to what extent? Measurement of the scale of financial flows when the rate of inflation has been both high and variable presents a challenging set of problems. Accounting data from balance sheets and income states are badly distorted by the presence of high inflation. To take two examples from 1997, when inflation in Romania exceeded 150%: (1) The nominal debts of loss-making Romanian firms to banks, government (unpaid taxes), and trade creditors all increased, but in real terms they all decreased. Without a closer look at the financial flows, one cannot say whether creditors were bailing out or hardening the budget constraints of these loss-makers. (2) Loss-makers in 1997 were making small losses before interest, taxes and depreciation, but very large losses after all financial and other costs. It is well-known (see, e.g, Schaffer 1993, 1998) that inflation can artificially inflate profits through the practice of historical cost accounting: purchase costs are understated relative to sales because of the increase in the price level between the time materials are purchased and the time the goods embodying these materials are sold. On the other hand, because inflation erodes the principal of a debt, nominal high interest rates can make profits looks misleadingly small because the nominal debt service burden in effect includes a component that is repayment of the principal. An additional factor is that unadjusted income statements and balance sheets do not capture the transfers to debts that occur when interest is charged at a negative real rate. Without a closer look at the financial flows, one cannot say whether the losses made by Romanian firms were larger, or smaller, than the unadjusted data suggest. The second objective of this paper is to present a comprehensive inflation-adjustment recalculation of both the profits/losses of the Romanian enterprise sector, and of the financial flows between it and its creditors. Our analysis uses a comprehensive dataset of Romanian firms for 1995-98 covering virtually all non- financial firms in Romania. We have data on the approximately 9,000 individual firms that are or were state-owned; in addition, we have aggregate data on the firms composing the rest of the Romanian enterprise sector. We divided these firms into three groups. The first is composed of the major Romanian utilities (Renel, Romgaz, SNCFR, Petrom). The second includes firms that existed before the Romanian economy started the transition to a market-based economy, other than the aforementioned utilities, and are or used to be state-owned. The third category is the rest of the enterprise sector, and is composed of all new private Romanian firms. Total sales and employment are divided approximately 50:50 between the two categories of state-owned and privatized firms on the one hand, and the new private sector on the other. The second group was divided into three subb- * We are grateful to Alan Bevan, Claudiu Doltu, Georges de Menil, Dragos Negrescu, Cristian Popa and Cornel Tarhoaca for helpful comments and suggestions. All remaining errors are our own. 1